Further oil demand destruction seems unavoidable

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Further demand destruction seems unavoidable

Yesterday, fears about economic headwinds and perhaps recession gained traction. China's GDP increased 3.9% in the third quarter. Although it was better than predicted, it fell far short of the declared aim of 5.5%. Worryingly, as President Xi Jinping tightens his grip on power, the communist party's congress made it quite apparent that national security will take precedence over economic interests. Chinese stocks plummeted, and the yuan fell. The Hang Seng Index dropped by more than 6%, while the Shanghai Equity Index fell by 2%. The morning sell-off was aided by a 2% decline in crude oil imports and a 36% increase in product exports in the world's second largest economy.

So did the manufacturing industries in the eurozone and the United Kingdom. In the eurozone, business activity fell for the fourth month in a row, with manufacturing feeling the brunt of supply chain concerns. In the United Kingdom, private sector activity decreased for the third month in a row, with the index falling to a 21-month low. Rishi Sunak, the incoming British prime minister, faces a difficult task in restoring economic confidence in a country that has entered a recession. The S&P Global Composite PMI Output Index in the United States has also shown decline in the manufacturing and service sectors. Following the "bad news is good news" cliché, bottom-pickers emerged in the equities markets, anticipating that the poor reading will induce the Fed to pause rate hikes, so lowering the currency, which is very improbable based on one piece of data.

…but structure implies limited downside for now

The two crude oil futures contracts are now trading lower than they were on February 23, the day before Russian forces invaded Ukraine. WTI is about $7/bbl lower than it was before the invasion, while Brent is about $3/bbl lower than it was on February 23. After decisively recovering from an early slump yesterday morning, CME RBOB finished around that level. Only Heating Oil and Gasoil are up from pre-aggression levels. Front-month heat is more over $1/gallon more than the February 23 settlement price, while ICE Gasoil is roughly $250/tonne higher. According to common belief, the two major crude oil futures contracts, together with RBOB, have lost all of their gains since the invasion.

When looking at the front-month contracts, the assertion is undeniably true. It, however, ignores the future market structure, which has been under persistent backwardation. In other words, a long position opened the night before the war's outbreak would still be profitable, simply because there have been seven monthly roll-overs since the end of February in a (often sharply) backwardated market. In the last eight months, front-month WTI has averaged a $1.66/bbl premium. Rolling the duration seven times yielded a profit of $11.60/bbl, which was greater than the drop in the front-month contract. The image is significantly brighter in Brent. Over the period, the average M1/M2 backwardation has been $2.35/bbl, or $16.45/bbl, which is substantially more than the anticipated loss in the outright price. Monthly RBOB contract rollovers have resulted in a gain of 79 cents/gallon, giving us a net profit of about 80 cents/gallon over the last eight months. In the case of heating oil and gasoil, an additional $1.51/gallon and $477/tonne should be added to the gross flat price increases, making the overall returns unquestionably fantastic.

This reversal is strong and lasting. When the front-month contract settled below $100/bbl in the second half of June, the premium on M1 WTI over M2 fell below $2/bbl. Since then, the outright price has dropped by $15 per barrel, while the backwardation remains above $1 per barrel. Brent's resiliency is more pronounced. A $7/bbl drop in flat pricing since the beginning of August has been accompanied by an increasing premium on the front end, which is now about $2/bbl. The price of heating oil has been on a roller coaster recently, but the current flat price decline has not been authorized by the structure; the front spread has grown from 6 cents/gallon in early July to 35 cents/gallon yesterday, while the outright price level has retraced. The same behavior may be seen in RBOB. The increasing backwardation does not support the flat price decline from the beginning of July.

Investor mood is deteriorating, as evidenced by lower outright prices, as a result of recession fears, increased borrowing rates, and a strong currency. Concerns about slowing oil demand growth were validated when major forecasting agencies revised their demand predictions downward in the middle of the month (the consensus figure for 4Q 2022 was -400,000 bpd and for 1Q 2023 was -530,000 bpd), and they may make additional changes in November. On the other hand, historically low inventories kept the futures market structure healthy. Commercial oil stocks in the developed world are unlikely to increase much in the fourth quarter of the year, especially if OPEC+ sticks to its word and decreases output by the anticipated 2 million barrels per day from the August limit. Product inventories are low, which is another positive element. In the United States, gasoline stockpiles are 7% lower than the 5-year average. According to the most recent EIA statistics, this disparity extends to 20% in distillates. According to PJK/Insight, gasoline supplies in the ARA hub may appear adequate in NWE, but they have plummeted over 20% in the last two months. Gasoline inventories are roughly two-thirds of the historical norm, a concerning trend ahead of the winter.

Clearly, outright prices have been deviating from spreads, or vice versa. The idea that recession fears and demand destruction will be the key driving forces in the next months may appear reasonable, but any downward price potential will likely remain limited unless these concerns are validated by dramatically weakening structure. And the narrowing of the backwardation could only begin to take shape if global and regional oil inventories begin to increase meaningfully; until then, the lure of higher returns given by the cheapening of longer-dated contracts down the curve will help put a floor under the market.

Plan tomorrow: As per yesterday I think we get a pretty big dip here and close that gap in the $80 range before heading back into the $90/barrel range. We have oil inventories tomorrow and that will give a decent indication of what the fundamentals are showing us.Oil prices are falling due to lingering demand concerns. Nonetheless, the supply side of the oil coin appears to be supportive. The IEA's head has emphasized the importance of Russian oil entering the market once a Western price cap is imposed. Meanwhile, according to a Reuters poll, US product stocks fell last week. Stockpiles of gasoline and distillate fell by 1.2 million bbls and 1.1 million bbls, respectively. In comparison, crude inventories are expected to have increased by 200,000 barrels.

The market squeeze continues but can it last?

For the past week, we've been in rally mode. Will it last? That, in my opinion, is a no. Even though I was playing on the long side today, we are very overbought here. Following such a massive squeeze, I anticipate a small dip and a consolidation phase leading up to the Fed meeting next week.

Why don't I believe the bottom has been reached? There are too many headwinds to count in this market to see any kind of light. There hasn't even been a panic day... But it's on its way. I believe we will take the red path over the next week or so.

Plan tomorrow: I think we chop between 3820 - 3860 and let things cool off. Bulls really can't lose 3800 for a risk of revisiting that lower trend line.

All eyes on the Fed next Tuesday.

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